There are, of course, no hard and fast rules, but this week I thought I would share some thoughts on what the industry terms ‘sell discipline’.
The first rule of selling is that it is better to sell early than too late, but the adage of better late than never still holds. Clearly, it is important to try to uncover something that will lead to future underperformance before such underperformance actually occurs. Is this easy? No, but often it is possible. We will come on to what to look for later. But it is of perhaps greater importance to avoid the obvious behavioural error of not selling because you have missed the boat – if a manager is underperforming, and you can identify why (and should have realised this earlier) should you wait for a potential recovery in performance? Definitely not, however much the contrarian in you might want to wait for a better exit point. If an investment thesis no longer holds, then you cannot have any real expectations for future performance, and therefore, in my view, it should no longer feature in a client’s portfolio. Continuing to hold because the current exit point feels bad (for example, selling at a loss) is a poor strategy where an investment thesis is broken. After all, the future exit point could well be worse.
So, if ideally we should sell before the manager begins to underperform, what should we look for? This is where small is definitely not beautiful. Analyse what a fund manager currently owns in his portfolio, and re-evaluate their holdings regularly – monthly is to my mind a sensible frequency (as well as being in line with most managers’ disclosure policies). For sure, look at the largest positions in a portfolio, and the major contributors to risk. But once you have done this, look at the smallest holdings. Is there a tail of small positions that is growing over time? And is this tail of stocks actually composed of names that the manager has reduced (or have underperformed, so shrunk) but the manager cannot bring him or herself to sell? When this happens, suddenly it can be the tail that wags the dog in terms of what drives future performance – which is often not a good sign. Of course, there are managers with a consistent ‘tail’ who deliver value, but a new found tail especially of positions a manager is not watching closely is definitely a red flag.
Related to this, what about the emergence of new, often small positions, in stocks that do not seem to fit with the manager’s philosophy and process. For example, the fund manager who tells you he buys beaten-up, deep value stocks that are priced for near-bankruptcy which the manager expects to recover, who has just bought a large-cap growth stock for their portfolio (or perhaps an ‘exciting’ small cap name). When you ask them why they own it, too often I hear “it’s too good an opportunity”, or even worse “I never said I was deep value”. I have heard the latter while looking at a slide from the manager entitled Deep Value Investing. The problem is that, despite what some of them might think, portfolio managers are human like the rest of us, and subject to the same whims as anyone else. So when something that seems a great idea comes along, often with a flurry of excitement, they might just be tempted to buy into it. But what makes a great portfolio manager is resisting that temptation – being oblivious and immune to such whims. Those managers who yield to this temptation should be sold before such stocks creep up and begin to dominate performance.
I began by saying that these were rules of when to sell fund managers. I am not sure that is fair – they are in reality guides, as for every time a rule makes sense to follow in investment management, there is another instance where doing the opposite is the right decision. There are many other reasons than those discussed here which should trigger the review of an investment thesis around a manager but, in general, thinking ahead, and questioning early, are definitely solid guiding principles. As is thinking small, because just as great oaks grow from small acorns, major problems can develop from small positions.
James Bateman is head of multi-manager and multi-asset portfolio management for Fidelity Worldwide
